Imagine your neighbor’s daughter sets up a lemonade stand.
Through a combination of sugar-heavy mixtures that delight the palate of her customers, the astronomical temperature outside, and a nearby parade, a long line forms.
After an hour, she’s forced to put the blossoming business on hold to go back inside and make more lemonade. Unfortunately, she’s out of sugar. She hadn’t planned on so much business, and hadn’t developed a safety stock in her production budget.
It takes money to make money, and the neighbor’s daughter — or more likely, her parents — hadn’t procured enough sugar to account for the demand. If she had looked at the weather forecast, discovered the parade announcement, or talked to some neighbors about their plans for the day, maybe they would have.
Budgeting is such an important part of any new product or service. You’ll only have enough money to launch a new venture if you spend the necessary time planning and strategizing the cost of producing a product for sale.
Below are seven things to know before finalizing your production budget:
1) Sales Forecast
A production budget is a combination of a sales forecast and how how many units to have on hand. A sales forecast is an informal sales budget — because it’s only looking at the near future and doesn’t have a lot of supporting detail — that projects future sales.
A sales forecast is bottom-up in that the sales team will determine the number based off the expectation of orders to the customers. It’s used to predict how many resources are needed.
In the lemonade stand example, the neighbor’s daughter forecasted a lower number of unit sales (glasses of lemonade sold) than was ultimately needed. Unfortunately, the little girl didn’t have a group of salespeople canvassing potential customers outside in the hot son.
2) Production Needs (aka Units to Have On Hand)
There’s a formula to figure out how many units to have on hand, an integral part of the production budget.
Expected unit sales + Units in desired ending inventory – Units in beginning inventory = Units to be produced. Sometimes the diction is different, so you can also calculate those production needs with this formula:
Forecasted unit sales + Planned finished goods ending in inventory balance = Total production required – Beginning finished goods inventory = Products to be Manufactured.
A less cluttered way of arriving at your total products to be manufactured: Expected sales (hence, no. 1: the sales budget), plus however many finished units are on your inventory, minus whatever finished goods you’ve started with.
Regardless of which formula you use, it’s necessary before you can finalize the production budget.
3) Direct Materials Purchases Budget (aka Raw Materials Inventory)
How much material are you going to need to start selling this product?
That’s basically what this boils down to, but there are different timeframes — monthly or quarterly — you can use to arrive at this number. And you don’t want to include finished goods or work-in-process goods (self-explanatory, but they haven’t finished being manufactured by the end of the timeframe) in this budget. Later, you’ll aggregate this total with work-in-process goods and the direct/indirect labor budget.
This budget computes a huge percentage of all costs, so it’s important to get this step right. You don’t want to overestimate or underestimate your costs.
4) Finished Goods Inventory
You need to arrive at the number of planned finished goods and beginning finished goods before you can finalize your production budget. It’s hard to sift through some of this, but a finished good has gone through the manufacturing process, or they’ve been purchased in completed form — known as merchandise — and haven’t yet been sold to the customer.
What finished goods are you starting with, and how many do you plan on ending with in the quarter or month makes up your inventory.
5) Direct Labor Budget: Direct Costs and Materials
Without these worked out, you can’t come up with a price for your product.
- Direct Costs – This could be wholesale products used for resale, raw materials you use to build your products, or the labor associated with creating the products. These are often variable costs that can fluctuate if you’re selling more or less of your product. In the example of the lemonade stand, it’s the lemons, the sugar, the water, any other products needed to squeeze the lemons and make lemonade, and the labor needed to actually create the lemonade.
6) Direct Labor Budget: Indirect Costs and Materials
Production costs are so important, both the direct and indirect costs play a role in how much you can produce.
- Indirect Costs – These are often fixed costs because they affect the company overall, and not just a single product; Basically, this is your overhead. In the case of the lemonade stand, it’s the neighboring girl’s parents who incur these: air conditioning and housing when making the lemonade, security to keep weird potential customers at bay, and space — the front yard and stand — needed to sell the lemonade.
7) Safety Stock
This is the all-important backup in case your forecasted levels are lower than the demand. If your neighbor’s daughter had a safety stock of sugar, she could have made continued making money at her lemonade stand. But safety stock isn’t just for raw materials, it can also be finished goods, like extra cups of the lemonade.
The formula used to compute safety stock is simple: Subtract the average daily usage from the maximum daily usage, and then multiply that number by the lead time (The total time required to place a new order and for a supplier to have delivered that order).
If you don’t use the formula, it can lead to an excess of lead time, which might be as costly as what happened at the lemonade stand. Depending on the product in question, it can lead to spoilage or holding costs that mess with the margins.